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The Universal Life Crisis: A Potential Fix for an Underperforming Policy

The
many advantages and disadvantages of a prolonged
low-interest-rate environment affect almost all
areas of clients' personal financial plans. For
example, low interest rates may be attractive to a
young couple applying for a mortgage to buy their
first home, but those same low interest rates on
bonds and CDs hinder the lifestyles of many
retirees on a fixed income. The interest-rate
environment can also have a dramatic effect on
universal life insurance policies.

Universal Life: How It Works

Flexible
premium adjustable life insurance is the technical
name for universal life insurance. Unfortunately,
it is commonly confused with whole life insurance,
since, unlike term insurance, it can remain in
force for an insured's "whole" lifetime.
Universal life operates differently from whole
life, however, primarily due to its flexibility in
making premium payments and transparency in policy
illustrations.

A
universal policy combines term insurance with an
interest-bearing savings account. Just like whole
life, the account value builds inside the policy
tax free if used to support the cost of the risk
at older ages. Unlike a whole life policy, a
universal life policy can be funded in ways that
best match a client with unpredictable cash flow.
This premium flexibility therefore makes regular
monitoring especially important to avoid
unpleasant surprises.

Issue: Lack
of Regular Monitoring

Universal
life policies are highly sensitive to both the
interest crediting rate and the choice by the
policy owner to adhere to the premium funding
schedule. The good news is that there is no
requirement to make a premium payment, or even
take a policy loan to make the premium payment, as
long as the cash value can otherwise support the
policy. That is the bad news, too. Not unlike
saving for a child's education, the flexibility to
choose not to make a payment may cause a shortage
when the policy is needed most. Coupled with an
assumption that interest would be credited at a
higher rate than actually achieved in the policy,
this could translate into a double disaster.

When
any "permanent" insurance policy is
purchased, certain assumptions have to be made by
both the buyer and the company selling the policy.
With universal life, the main assumption is the
future crediting rate of the policy, which in turn
determines the annual premium. This means that the
higher the interest crediting rate, the lower the
premium, based on current insurance
charges.

The
buyer also has the option to make an assumption
about life expectancy. In many cases, the buyer
can either purchase the policy to "full
duration," which can be up to age 121, or
select a shorter life expectancy. A universal
policy with an assumed death by age 90 could have
much lower premiums than one that will pay a death
benefit even if the insured dies well past age
100. Depending on the carrier, the most dramatic
pricing difference can be found in a wider age
spread. Whatever the buyer selects for the
"assumed policy duration" along with the
assumed future crediting rate is then captured in
the "as sold" illustration at the time
of purchase. This illustration should be retained
along with the original contract in the policy
owner's files for future reference.

Unfortunately,
in most cases, the "as sold"
illustration is only as good as the paper it is
printed on, since the policy owner can alter the
premium funding, and the insurance carrier can,
and likely will, change the interest crediting
rate throughout the life of the policy. The
illustration can provide historical perspective,
but, as with most investments, both funding and
earnings can invalidate the expected results.

Oddly
enough, the policy owner is not informed of any
negative effects until the policy may be close to
lapsing. This is not only disastrous for
beneficiaries expecting a death benefit, but also
for an unsuspecting trustee if the policy is owned
by a trust. A trustee has the fiduciary
responsibility to maintain the policy in good
standing under the same standards as any other
investment. This applies even to the unsuspecting
friend or family member who is named as trustee.
To fulfill this duty, the trustee should meet with
the agent, broker, or consultant at least annually
to review the policy's performance.

Potential Solution: Revisiting Life Expectancy
Assumptions

Although
the common approach to "fixing" an
underperforming policy is to exchange the policy
for a new one if the client is still in good
health, this may not be the best route. It may be
more prudent to revisit the assumptions made when
the policy was purchased, along with the current
goals of the policy. In the past 10 years,
carriers have decreased their crediting rate by
50% or more in some cases. When compared with the
"as sold" illustration, this dramatic
decrease can translate into a significantly lower
cash value inside the policy. Do not stop there,
however, since the original assumption of policy
duration must also be revisited.

The
solution to fix an under-performing policy due to
a lower interest crediting rate may come from the
assumption that the policy was scheduled to last
to age 100+. Depending on the client's current
health, this now may be unnecessary. A younger age
assumption for the policy duration may be
adequate. A significantly younger age may also be
appropriate if the insured has had serious health
issues. The first step is to determine the health
of the policy, and the second step is to determine
the health of the insured.

Step 1. The health of the
policy:An
"in-force ledger" can be provided by the
servicing broker to solve for the years the policy
will stay in force based on the current cash value
and a future assumed crediting rate. It is also
prudent to run the in-force ledger at the
guaranteed minimum crediting rate. Note that on
older policies this rate could also be the current
crediting rate.

Step 2. The health of the
insured:In
addition to a general discussion of the insured's
medical and family history, a new tool can be
used, called a life expectancy quote. This can be
requested from companies that specialize in
reviewing an individual's health records to
determine how long the client may live. Other than
an unhealthy young client, this generally only
makes sense with a client who is age 70 or older
to have any chance of relying on the results. Life
expectancy quotes may not be worth much, either,
but many consider them better than guessing how
long the insured may live. The insured's life
expectancy can then be matched to the duration of
the policy, as explained in the previous
paragraph. If the life expectancy quote results in
an age that is longer than the current cash in the
policy can support, the policy owner may choose to
put additional funds into the policy or perhaps
reduce the death benefit to match the insured's
life expectancy. Since this is not an exact
science, the broker or consultant should present
several alternate plans if the insured lives
beyond the premium funding solution chosen. These
can be easily laid out and discussed with the
policy owner and are essential if the policy is
owned by a trust for legal/fiduciary protection.
It should then be monitored each year.

Sample Analysis

The
sample exhibitoutlines
a case recently provided to a fellow CPA to help a
77-year-old client save thousands of dollars of
unnecessary premiums. The CPA, who was also the
trustee, felt that since the policy experienced a
200 basis-point drop in the interest crediting
rate for several years, it must have meant that it
was time to increase the annual premium to make
sure the policy would stay in force. The original
premium was scheduled at $85,000 per year, but the
"revised" premium provided by the agent
to make up for the loss of interest credited was
thought to be $131,000. However, this was based on
a guess that the insured would live to age 95.
After the analysis was done and the insured's life
expectancy was estimated at 7–10 years, the more
appropriate premium was estimated at between
$62,000 and $93,000. Ironically, after reviewing
all options as detailed on the downloadable
spreadsheet, the trustee resumed the original
premium schedule, but now with the knowledge that
the damage done by the drop in the interest
crediting rate was mitigated by the insured's life
expectancy. The sample analysis can be provided to
any agent or consultant to guide the CPA through
the best decision for his or her
clients.

Conclusion: Comprehensive Analysis Is
Essential

The
flexible structure of a universal life policy is
attractive at the time of purchase, but it must be
managed properly. If a policyholder skips a
premium and/or the carrier credits the policy at a
lower-than-expected interest rate, the policy
could lapse well before it is expected to. The
immediate solution is almost always assumed to be
either to purchase a new policy or pay higher
future premiums in the current policy, but that is
not necessarily the case. If the owner is willing
to do some homework with the servicing broker or
pay a consultant to perform a comprehensive review
of options, it is quite possible to save thousands
of dollars. The results may show that higher
premiums are not necessary, and in some cases
there may even be a lower premium than was
originally planned at the time of purchase,
despite low interest rates.

From
the policy owner's perspective, the goal for any
universal life policy purchased with a level death
benefit is to die with $1 of cash value. Without a
crystal ball, this is nearly impossible, but it is
much more likely if the owner understands and
manages the variables of universal life policies.
Quantifying how much to fund a universal life
policy is critical to maintaining and preserving
this valuable asset.

Contributors

Theodore
Sarenski is president and CEO of Blue
Ocean Strategic Capital LLC in Syracuse, N.Y.
Susan
Bruno is managing partner with Beacon
Wealth Consulting LLC in Stamford, Conn. Mr.
Sarenski is chairman of the AICPA Personal
Financial Planning Executive Committee's Elder
Planning Task Force and is a member of the
AICPA Advanced Personal Financial Planning
Conference Committee and Financial Literacy
Commission. For more information about this
column, contact Ms. Bruno at sbruno@beacon-wealth.com.

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